MUMBAI: A complex strategy being adopted by foreign institutional investors (FIIs) shows their renewed bullishness towards India despite the Nifty having crossed two-year highs recently. FIIs began playing an interesting derivatives strategy called 'covered call and protective put' last week.

They initiated the strategy when Nifty futures traded around 6050-6070, hoping the index would rise to 6100 or slightly above that level till the RBI's policy declaration on January 29. The markets have priced in a 25-basis points cut, but analysts say indices could correct by 5-7% if the central bank does not cut rates.

The three-pronged strategy involves buying index futures first to profit from a rise in markets and to maximise their cash holdings. On the second leg, FIIs purchase index put options giving them a right to sell the Nifty index if the market falls below a certain level called the strike price. On the last leg, they sell index call options to negate the outflows from the purchase of index futures and index put options.

The strategy is complex, but can be simplified. Based on last Friday's levels, an FII, which owns shares comprising Nifty 50, purchases Nifty index futures around Friday's closing levels of 6070 for Rs6,070 as it feels the index could rise to 6100 following a postponement of anti-tax avoidance rules and partial decontrol of diesel prices, which would increase foreign inflows and narrow the fiscal deficit.

However, to protect itself from an unexpected fall, the FII also buys a Nifty put option of 6100 by paying a premium of Rs66 to ensure that if the index falls from the current levels, the gain on the put will partly offset the loss on long index futures.

The expense of Rs6,136 (6070 on the futures plus 66 on the call) is partly negated by the FII selling a call option of 6100 strike - the price at which Nifty can be purchased even if the index exceeds that level - for Rs40. Thus, the FII's outflow is reduced to Rs6,096 (6136-40 premium received).

If the Nifty rises to 6100 by January end or earlier, the FII's profit, excluding STT and other taxes, will be Rs4 (40 premium on call plus 30 rise of index futures minus 66 loss of premium on put), apart from an notional gain of Rs30 on its cash market holdings of Nifty shares. This is because the rise in the Nifty will be reflected in Nifty constituents.

However, instead of rising by 30 points to 6100, if the Nifty falls by 30 points from Friday's level of 6070 to 6040, the FII will still be left with a profit, ex-taxes, of Rs4 --(40 plus 30 which was received on put position) minus 66 (fall in index futures and part loss on put).

There will, of course, be an unrealised loss of Rs30 on their cash portfolios, but FIIs have initiated this strategy because they are bullish, say derivatives analysts.

"As on January 17, FIIs cumulative index future longs stood at 205,900 contracts, while their index futures shorts stood at 33,753 contracts, indicating their preference on the long side of the markets for the current expiry," added HSBC InvestDirect's Mutha.

The brokerage's data for last Thursday shows FIIs had a cumulative long position in puts of 746,598 contracts, signifying hedges for long Index and underlying cash market positions. Further, they have written index call options to the extent of 339,026 contracts, mostly beyond the 6100 strike, to negate the premium outflow on long puts.

Various other market experts hold a positive view on stocks. Motilal Oswal, chairman & MD, has a positive view in the medium term.

"FIIs continue to remain bullish on markets while retail investors have begun investing once again, thanks to the government's recent reform push," said Oswal. "Only domestic institutions, facing redemptions, continue to be the sellers."